Finland’s
depression in the early nineties was not just the result of the collapse
of its major trading partner, the Soviet Union, and the sharp rise in
European interest rates. A new study by two leading economists from the
University of Helsinki, Seppo Honkapohja and Erkki Koskela, shows that
poor institutions and poor policies made a bad situation worse. Their
work appears in the October issue of the journal Economic
Policy.

Finland’s
real GDP dropped by about 14% from its peak in 1990 to 1993. By 1994
unemployment had reached nearly 20%, up from 3% four years earlier.
According to the authors, the story begins with a poorly designed
deregulation of financial markets. After deregulation, the authorities
decided to stick with a fixed exchange rate regime. The private sector
built up heavy foreign debts and subsequently interest rates started to
rise as a result of emerging credibility problems and developments in
Western Europe.

“Finland’s depression was due to a classical financial
crisis and offers some comparisons with Chile, Mexico, some east Asian
countries and Sweden”, say the authors.The economy up to 1990 had been stable, and had not suffered the
rise in unemployment that hit most OECD countries after the oil crises
of previous decades. But inflation started to take off in the late
eighties.

In
1991 trade with Russia dropped by 70%: the timing was bad for the hard
markka policy which had been introduced in 1989 and was rigorously
pursued until the currency was allowed to depreciate in November 1991.
It was also in 1991 that the authorities tightened bank supervision and
prudential regulation. Rules in these areas had been left unchanged
during the period of deregulation which began nearly a decade earlier.
Many factors contributed to a surge in bank lending and real asset
prices during the boom: when policy was tightened, lending dropped by
25% and asset prices halved.

That
meant substantial bank losses while the depreciation of the markka
raised the real burden of foreign debt servicing: the share of foreign
currency loans in total lending was about 15%.

Honkapohja
and Koskela write “International illiquidity, real exchange rate
appreciation and lending booms are central characteristics of many
recent crises that followed financial deregulation”.Although Finland eventually recovered, their research shows that
the equilibrium rate of unemployment increased due tothe crisis.

The
lessons of the Finnish crisis are far-reaching. Deregulation drove
saving rates to zero and then high interest rates pushed them up
sharply. Asset prices displayed the opposite movement. The authors show
that direct financial restraints played a large part in cutting
aggregate demand.

Finland
presents a classic case of how everything went wrong together. Tight
monetary policies were imposed on a highly indebted corporate sector in
the context of a tax system which favoured debt over equity finance.
Borrowing abroad was encouraged by a hard currency policy and a fixed
exchange rate. The authors say a flexible exchange introduced earlier
would have helped. They add: “One clear lesson is financial market
deregulation should not be carried out in isolation. It should include a
reform of the tax system and tightened bank supervision.”

Notes
for Editors :

Economic
Policy is published in association with the European Economic
Association for the Centre for Economic Policy Research, the Center for
Economic Studies of the University of Munich and the Département et
Laboratoire d’Economie Théorique et Appliquée (DELTA), in
collaboration with the Maison des Sciences de l’Homme.